Harry Huizinga (Tilburg University and CEPR) Johannes Voget

1. Capital Gains Taxation and the Cost of Capital: Evidence from Unanticipated Cross-Border Transfers of Tax BasesAEA 2012 Harry Huizinga (Tilburg University and CEPR) Johannes Voget (University of Mannheim, Oxford University Centre for Business Taxation) Wolf Wagner (Tilburg University, Duisenberg School of Finance)

2. Motivation • Capital gains taxation reduces attractiveness of assets • This has the potential to increase cost of capital in the economy • Identification of impact of cost of capital challenging • Tax burden reduced by deferral and trading strategies • Tax changes are endogenous and infrequent • Confounding lock-in effect in secondary markets: acceleration of accrued gains drives up prices

3. This paper We use cross-border takeovers to estimate tax effects • A (cash-financed) cross-border takeover transfers the tax base associated with future capital gains from target shareholders to acquirer shareholders   • These two groups of shareholders are subject to different capital gains tax regimesin cross-border mergers • Future tax burden discounted in takeover price • This permits estimating the costs arising from the taxation of future gains

4. Advantages of approach • Considerable variation in capital gains tax regimes across countries: average long term tax change triggered by takeover is 13.6% in our data • Changes in applicable capital gains taxation triggered by international takeovers are generally unexpected • Tax system is exogenous to individual cross-border transactions • No confounding of capitalization of future taxes and lock-in effects

5. Previous literature • Protopapadakis (1983) provides evidence on effective capital gains taxes for US investors over the 1960-1978 period by looking at actual portfolio appreciations and capital gains tax liabilities • Dai, Maydew, Shackelford and Zhang (2008) find evidence of both capitalization and lock-in effects in share prices in the secondary market by considering equity pricing before and after the 1997 US capital gains tax rate cut • Ayers, Lefanovitz and Robinson (2003) study the takeover premiums of domestic mergers in the U.S. and find that they reflect tax burdens on prior stock appreciation • Sialm (2009): exploits time-series variation in US shareholder taxes to study how these taxes are capitalized in prices

6. Identification of Capitalization Effect Consider a cash-financed takeover of a firm located in country i by a firm in country j. Denote with ti and tj the long-term tax rates in both countries • After the takeover, firm will be owned shareholders of acquirer firm. These shareholders then expect future capital gains to be taxed at the acquirer country rate tj • Prior to takeover, shareholders expect future gains to be taxed at target rate ti • Cross-border merger induces change in expected taxation of future capital gains of tj – ti • By relating the takeover premium to this tax change we can estimate tax cost as perceived by shareholders

7. Other Tax Consequences of Takeovers Lock-in effect: • Cash-financed takeover forces target shareholders to realize accrued gains. This increases reservation price and should increase takeover premium. • This effect is related to the difference between the short and long term rates of the target country (si – ti) or the long term rate of the target country (ti ) Note: Capitalization effect driven by cross-border differences in tax rates while lock-in effect driven by target rates Equity-financed transactions: do not have any tax consequences Choice between equity and cash finance: equity more likely to chosen when cash financing has negative tax consequences.

8. Data • 9340 takeovers involving 33 countries in period 1985-2007 (Thomson Financial) • Hand collected data on country capital gains tax regimes (includes backward and forward-looking information) • Complementing accounting and share price data from Compustat and Datastream

9. Capital gains tax rates for long holding period 1985-2007

10. Capital gains tax rates for short holding period 1985-2007

11. Sample split into low and high tax takeovers

12. Dependent variable: Takeover premium

13. Implications for takeover costs • -0.136 is the estimated coefficient for the cross-border tax difference variable • 24.2 is the average long-term capital gains tax rate • Hence, the average acquiring firm pays 3.29%(=0.136*24.2) less on account of capital gains taxation of its shareholders

14. Implications for effective tax rate of capital gains • The effective capital gains tax is the ‘the tax rate on capital gains that, if levied continuously, would leave the investor with the identical wealth as a capital gains tax, τ, levied when the capital gains tax are realized’ (Protopapadakis, 1983) • The effective rate of tax will be less than the statutory rate of tax, τ, because of allowed deductions (of realized losses on other shares), exemptions, and the fact that investors only pay taxes when they realize their capital gains • Using historical data on capital gains shares in total shareholder returns (72% in the MSCI world) we can compute effective capital gains tax rate as 4.57% in absolute terms or as 18.9% of statutory tax

15. Implications for cost of capital • When firms issue new equity, only capitalization effect is present • Using historical rate of return, we can calculate the impact of capital gains taxation on the required return on equity as 3.41% • This number may underestimate the impact on cost of capital because • We only estimate incidence of acquirer-country capital gains taxes on target-shareholders (but: M&A literature suggests that incidence is largely on target shareholders) • Firms that issue equity for real investment may be young and fast-growing, with larger part of shareholder return in the form of capital gains • Young firms may have lower share of foreign shareholders

16. Evidence on other tax consequences • We find evidence of lock-in effect arising from fact that target shareholders will forced to tax gains are short-term rate • No evidence for lock-in effect arising from long-term rate • No evidence for tax effects in equity sample • Both capitalization and lock-in effects affect mode of payment in takeover

17. Conclusions • This paper uses tax changes triggered by cross-border mergers to estimate impact of capital gains taxation • A one percentage point increase in the acquirer-country capital gains tax rate reduces the takeover price by 0.136% • Based on that, the average statutory capital gains tax (24.2%) increases the cost of capital by 3.41%. • Tax exportation: high capital gains tax countries benefit through lower premium paid by their acquiring firms

18. Capital gains taxation of individuals in 2007

19. Choice of payment